Key Takeaways
US and European growth rates are converging as the US slows down and Europe, including the UK, picks up.
US rate cuts have largely been priced out in the markets creating scope for a rally should there be a surprise.
In Europe, the ECB has essentially promised to cut rates this week. Attention will therefore focus on hints for future guidance.
In the UK, recent economic data have been much stronger than expected. Inflation has fallen too but the Bank of England won’t want to cut rates in the middle of an election campaign.
So much has happened since my last Market Perspectives. A host of elections, the conviction of former President Trump and of course loads of economic data. My focus today is on the economic outlook and what it means for interest rates – with the ECB set to cut rates this week – and financial markets.
Let’s start with economic growth. The pattern here is clear: slowdown in the US, pick up in Europe and the UK. Given the starting point, with the US much the stronger over the last year or so, this amounts to convergence. The slowdown in the US is actually good news because it offers the hope that the Federal Reserve will start to cut interest rates.
The US slowdown is driven by the consumer, who is over extended and faces a slowdown in real income growth. I don’t see any risk of recession in the near term and softer demand should take the edge of inflation. We’ll see what the employment data show at the end of this week but I reckon they’ll be consistent with the slowdown thesis. With so much optimism on rate cuts having been priced out in the US – market pricing shows only one cut by year end – there is plenty of scope for a rally. I’ve discussed the reasons for sticky inflation in the US many times before – principally rents and the absurdly high weight given to them in the US inflation indices. It’ll be a slow process but US rates are headed gradually lower.
Over in Europe, the ECB has essentially promised to cut rates this week. Market attention will be focussed on what Christine Lagarde says in her press conference. Expect a neutral outlook. I expect ECB rates to fall by a quarter of one per cent each quarter over the next year. Yes, that’s fully priced in but a positive background nonetheless. And growth is picking up, albeit from anaemic levels. Deutsche Bank, for instance, have just added half a percent to their 2024 GDP forecast. That’s a big change. Much of the improvement is down to the consumer, who starts with a high saving ratio and improving real income growth. The exact opposite to their US cousins.
It’s a similar but even stronger story in the UK. Recent economic data are coming in much stronger than expected. Inflation has fallen too. The problem is wage inflation, falling yes but still too high. Data this week are likely to confirm this. The 10% hike in the minimum wage is largely to blame but wage inflation should slow markedly going forward. Another negative relates to household energy bills. These have fallen heavily and will fall again in July but the October price cap looks like coming in at £1,762. That’s an increase of 12% from the July number. That in turn reflects a pick up in natural gas prices. All this makes it easy for the Bank of England to remain on hold when it meets later this month – they wouldn’t want to cut rates in the middle of an election campaign. I reckon they’ll cut at the following meeting in August. That’s ahead of market pricing.
Economic recovery, falling inflation and lower interest rates add up to a favourable background for both bonds and equities in my view.
